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Climate change

May 20, 2008

I am testifying this morning on climate change before the Senate Committee on Energy and Natural Resources. Reducing greenhouse-gas emissions would provide benefits to society by helping to limit the damage associated with climate change, especially the risk of significant damage. The testimony focuses on ways to reduce the economic cost of achieving any given greenhouse gas emissions target. In particular:

Market-oriented approaches to reducing carbon emissions, such as a cap-and-trade program, would reduce emissions more cheaply than would command-and-control approaches, such as regulations requiring across-the-board reductions by all firms. Those market-oriented approaches are relatively efficient because they create incentives and flexibility for emission reductions to occur where and how they are least expensive to accomplish.

The cost of meeting an emission target with a cap-and-trade program could be reduced, potentially quite substantially, by providing firms flexibility in the timing of their efforts to reduce emissions. In its most inflexible form, a cap-and-trade program would require that a specified cap on emissions was met each year. That lack of flexibility would increase the cost of achieving any long-term goal because it would prevent firms from responding to year-to-year differences in conditions that affected costs for reducing emissions -- such as fluctuations in economic activity, energy markets, the weather, and the technologies available for reducing emissions. In contrast, because of the long-term nature of climate change, the key issue from an environmental perspective involves the long-term emissions and concentration paths of greenhouse gases, not the year-to-year fluctuations in emissions. The most cost-effective cap-and-trade design would thus encourage firms to make greater reductions when the cost of doing so was low and would allow them leeway to lessen their efforts when the cost was high. Providing firms with such flexibility could also prevent large fluctuations in the price of allowances that could be disruptive to the economy.

One option for allowing firms flexibility in determining when to reduce emissions while also achieving compliance with a cumulative emissions target would be through setting both a ceilingtypically referred to as a safety valveand a floor on the allowance prices each year. The price ceiling would allow firms to exceed the annual target when the cost of cutting emissions was high, while the price floor would induce firms to cut emissions more than the annual target in low-cost years. The price ceiling and floor could be adjusted periodically to ensure that emission reductions were on track for achieving the long-run target; such a dynamic price system could substantially reduce the cost of a cumulative emissions target.

Policymakers choices about whether to distribute the allowances without charge or to auction them -- and if auctioned, how to use the proceeds -- could also have a significant effect on the overall economic cost of capping emissions. Evidence suggests that the cost to the economy of a 15 percent cut in U.S. emissions (not counting any benefits from mitigating climate change) might be half as large if policymakers sold the allowances and used the revenue to lower current taxes on capital that discourage economic activity, rather than giving the allowances away to energy suppliers and energy-intensive firms or using the auction proceeds to reduce the costs that the policy could impose on low-income households. Using the allowances value to lower the total economic cost could, however, exacerbate the regressivity of the policy change.